The Power of Compound Interest

I recently had a meeting with a potential investor that asked me “Why do I need to start investing so early? I have at least 25 years before I retire.” I swiftly busted out my financial calculator and taught him the magic of compound interest. Yes – I carry my financial calculator around with me and yes I’m a geek for numbers and investment returns.

For those that aren’t aware of what compound interest is, don’t feel bad as personal finance and investing wasn’t something that was taught in school. Compound interest is simply earning interest on interest. Here’s a basic example:

If you invest $100 today and earn 10% interest, you’ll have $110 at the end of the year. In year two, you’ll start with $110 and end up with $121. This is because you earned 10% on $110 instead of your original $100. While these numbers are small, the effect gets much more noticeable the longer you allow your money to grow which you’ll see below.

The chart above illustrates an investment of $500 a month ($6000 per year) earning 10% annual interest. The blue bars are what happens to your money over 15 years while the green bars represent the same investment but over 25 years. I left out taxes to keep this example more simple.

In 15 years, you’ll have invested a total of $90,000 ($6000 x 15 years) which will grow to $200,000. Pretty solid for $500 a month.

If we look at the same investment over 25 years, you’ll have invested a total of $150,000 ($6000 x 25 years) and your money will grow to approximately $620,000! That’s a gain of over $400,000 in the last 10 years alone.

This is because as your investment grows, you keep earning interest on all that other interest you earned over the years. This is why compound interest is so important. The best way to have it work in your favour is to let it work for as many years as possible.

While the concept is simple to understand, not enough people take advantage of this. Invest for as long as you can, invest consistently, and invest smart; you’ll be amazed at what you will accomplish!